US Deficit Failure Turns Spotlight on Tax Reform

For the U.S. economy to prosper, major tax reform is emerging as a vital ingredient toward lowering the U.S. budget deficit and increasing America's competitiveness.

Yet the acrimonious collapse last week of talks in Congress to start fixing the U.S. budget deficit has left the country at a political standstill and limits the prospects for a tax overhaul.

President Barack Obama and his likely Republican challenger in 2012, Mitt Romney, show little zest for making tax reform a centerpiece of their campaigns which would give them a mandate for overhauling a system riddled with loopholes.

That further lessens chances for breaking the budget deficit deadlock this year or even next.

The potential cost to the United States is very slow progress in lowering the national debt burden, lost economic growth, downward pressure on the dollar and eventually the risk of higher interest rates.

It also could speed the erosion of U.S. global leadership as less-indebted emerging economies expand.

"I am pretty pessimistic," said Howard Gleckman, a policy analyst at the bi-partisan think tank Tax Policy Center. "And yet the need for this grows all the time. The tax code is less and less able to generate the revenues for the size of government that we want. It gets worse with the aging baby-boomers."

Under the current budget trajectory, by 2018 basic federal programs such as disability support would run out of money, and by 2029 Medicare, the healthcare program for the elderly, could not pay hospital bills, the Center for Budget Responsibility estimates.

The case for a new approach has grown more urgent in the wake of the failure of the congressional "super committee", after three months of debate, to agree on how to cut at least $1.2 trillion from the federal budget deficit over 10 years.

That sum, which is due to be made in automatic spending cuts, represents just a downpayment on the huge deficit reduction required to get the U.S. budget under control and pay basic bills.

Taxes were the big stumbling block in the super committee.

The two extremes in the tax debate -- those on the Republican right and energized by the Tea Party who have signed a pledge to never raise taxes, and those on the Democratic left and personified by Occupy Wall Street who want millionaires to pay more -- are sucking the air from the moderate middle.

"It is the only way to save the country -- tax reform and fiscal consolidation. Everything else is the road to ruin," said Kevin Hassett, director of economic policy studies at the American Enterprise Institute, a conservative think tank.

SEEKING A MANDATE

Republican candidates for the party's presidential nomination Herman Cain, Rick Perry and Newt Gingrich have proposed major tax reform plans that would simplify the code, lower rates and rid the system of many loopholes.

The corporate tax rate in particular would be slashed. The trade-off is that special interest tax breaks would be sacrificed in exchange for a simpler system.

But all three are long shots at best to win the Republican ticket. Romney, who is most widely expected to take on Obama, has proposed tinkering with the current, labyrinthine system.

Obama is milking the tax debate, painting Republicans as cosseting millionaires at the expense of the poor.

"The debate has gotten stuck in a political standoff," said Mark Robyn, an economist at the Tax Foundation.

As long as each side demonizes the other, progress on deficit reduction will be difficult.

Several steps are needed to create a breakthrough, and tax reform is central, analysts said.

First, politicians must agree on how much revenue they want to raise, and then decide the tax rates to achieve that.

One starting point could be total federal government revenues at 18 percent of GDP. That is the average level since 1945 but above the estimate of about 15 percent in the 2011 fiscal tax year, the lowest since 1950.

That 18 percent level was used when tax reform was last achieved in 1986, under President Ronald Reagan.

Without a common starting point, the political argument gets stuck on specifics — right now over retaining the Bush-era tax cuts or extending payroll tax cuts.

Secondly, tax reform requires political leadership.

Obama or his Republican challenger would need to seek an electoral mandate for a system that is fairer, more efficient and more competitive. The winner of the November 2012 elections could then press forward with tax reform in 2013 as part of a broader budget deficit reduction plan.

A simpler tax code could broaden the base of taxpayers by removing loopholes, lowering the overall rates and achieving the revenues agreed upon.

"We're going to keep moving forward with tax reform...It's probably more realistic to look at 2013 for action because election years are really tough," said a senior congressional aide, who requested anonymity.

The chairman of the Senate Finance Committee, Max Baucus, a Democrat of Montana, wants change. "Tax reform needs to bring efficiency, simplicity and fairness to the system. Done right, tax reform can spark job creation and widespread growth and help U.S. businesses compete in the global economy," he told Reuters.

Former Soviet states that adopted radical tax plans such as a low flat rate enjoyed strong growth. President Reagan's 1986 reforms, which after two years of haggling resulted in a cut to the corporate rate, helped lay the foundation for strong U.S. economic growth in the 1990s.

COSTLY TAX REGIME

The urgency for action is mounting. Total U.S. debt to GDP hit 100 percent this year and under its current trajectory would exceed 115 percent of GDP by 2016, according to International Monetary Fund figures, above levels that have caused sovereign debt crises in European countries.

It already has triggered a ratings downgrade from Standard & Poor's with the threat of more to come.

The U.S. debt-to-GDP ratio averaged 62 percent between 1995 to 2004, before the Bush tax cuts threw spending and tax revenues severely out of kilter.

Economists Carmen Reinhardt and Kenneth Rogoff estimate that countries with debt levels above 90 percent of GDP have output that is 1.3 percentage points lower than less-indebted countries. Large public debt can undermine the value of the currency, raising import prices, making it harder to attract capital and pushing up interest rates. This hits growth.

A complex tax code also has hidden economic costs.

U.S. taxpayers spend 6.1 billion hours, or roughly one full working week each year, preparing tax forms and on average fork out $258 on tax consultants, the National Taxpayer Advocate, a watchdog for the Internal Revenue Service, estimates.

No wonder they have to spend so much time and money on tax preparation when the number of special tax deductions have increased 2-1/2 fold since 1980, distorting investment decisions such as whether to buy or rent a home. Tax breaks have multiplied in recent decades becoming a favorite tool of government to achieve policies that would otherwise be blocked by a Congress reluctant to approve new spending programs. The resulting complexity causes somewhere in the realm of $150-$200 billion annually in lost output, tax experts estimate.

"No one in their right mind would have designed from scratch the tax code the way it is now," said Robyn at the Tax Foundation. "Everyone agrees that the tax code is broken...but no one can agree how to (fix) it."